The ECB cannot save Spain

Juan Ramón Rallo

13 August 2012

Madrid's persistent pressure for the European Central Bank (ECB) to monetise part of its debt is necessarily a self-defeating strategy. Once the Spanish government recognises that it is unable to restore the credibility of its liabilities and that the sole purchaser that can be expected to appear in a worldwide capital market is the central bank, the distrust in its debt can only increase.

On these grounds, it is not clear why the ECB should do precisely what most private investors dare not do, i.e. buy massive amounts of Spanish national debt. Naturally, it could be argued that a central bank’s role is to solve liquidity problems amidst a panic, but its role is certainly not to cure solvency problems. As no debtor can become solvent by rolling over its liabilities (much less by increasing them), there is no point in providing new and growing amounts of funding to already over-indebted agents. And for this reason, quite contrary to mistaken perceptions, the ECB is already imprudently providing too much cheap credit to the over-indebted Spanish economy: around €400 billion to the banking system and some €50 billion to the government.

That is to say, the ECB is directly lending to Spain more than 45% of its GDP (twice the amount which the Federal Reserve or the Bank of England are extending to their economies). Most of this credit is being employed to offset foreign capital outflows and thus is an attempt to stabilise the economy by avoiding much more critical scenarios.

But such stabilisation measures have proven deficient for deterring those capital outflows in recent months and there is no reason to think that it will prove different in the future. If private investors are concerned about the long-term solvency of Spain’s economy, the remedy cannot be found in lighter conditions for getting into more debt. Of course, if the expectations are that the ECB will buy more public debt over the next few months, there will certainly be some speculative front-running which will reduce temporarily interest rates. But that would be only a way of hiding Spain’s problems, not of solving them: real solutions can only come from improving Spain’s solvency by balancing the budget with deep spending cuts and by accelerating the liberalisation of the economy.

The Spanish government’s strategy seems to rest on the dangerous assumption that it has already enacted all the reforms needed to restore long-run creditworthiness and that the country just requires some extra time until those adjustments take full effect and are acknowledged by the market. Consequently, it is the mission of the ECB to step in and buy Spain that time. The problem is that remarkably few investors are accepting this highly optimistic hypothesis, basically because there are very good reasons for believing that the core problems of the Spanish economy still remain mostly unaddressed: unsustainable structural deficit levels, oversized public spending, high tax rates, rigid and overregulated markets, potential social unrest and dysfunctional governments at all levels.

In this context, what would be the purpose of a massive debt purchase by the ECB? To give Spanish politicians more time to implement new cuts and intense reforms, maybe under the European intervention umbrella? Or, more plausibly, to offer artificially cheap credit to the Spanish authorities so that they can further delay the vital adjustments needed to bring back financial soundness? In the first case, ECB credit would not be necessary for stabilising Spain’s debt crisis, since the same investors who are now fleeing Spain due to long-term risks would return once those risks were dispelled. In the second scenario, ECB credit would be insufficient to solve the underlying problems after the short-run speculative euphoria went away and private creditors were subordinated to the ECB. As the Bundesbank and even the ECB have constantly stressed, it is not the role of a central bank to fix any country’s fiscal issues.

The problem with Spain is one of multiple equilibria for bond yields. If yields were low, then Spain's debt load would be manageable (given a long-term federal solution for the Eurozone) - justifying the low yields. However, when yields are high, then default risk starts to become a problem, justifying the high yields. ECB intervention is perfectly justifiable in order to move from the 'bad' equilibrium - high yields - to the 'good' one. Indeed, if the ECB hadn't been so very publicly hesitant to buy Spanish bonds - if it had never been in doubt that they were willing to intervene - it is highly unlikely that the situation would have got this bad in the first place.

Not really. Spanish primary deficit is around 6-7% of GDP. The problem does not come from the rising financial costs, but from the structural budget imbalance. ECB interventions would help almost nothing and, since they could delay spending cuts, they would in fact worsen the problem.

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